Stock Smarts: Is The Bull Market About To Crash?

The bull market continues to run but a growing number of experts say it might be at its tipping point.

This year’s winner of the Nobel Prize for Economics admits he is nervous about the stock market.

Richard H. Thaler, who won the award in part because of his contributions to the understanding of behavioural economics, told Bloomberg: “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.”

There was a lot more but because his comments were fully reported in The Globe and Mail and other media I won’t repeat them again. Suffice to say he doesn’t like what he is seeing in Wall Street, Washington, or London, where the British are still figuring out how to cope with Brexit.

He’s not the only one that has expressed concern about high share prices. Yet investors don’t want to listen. The Dow, Nasdaq, and S&P 500 set more new records last week and the TSX is edging closer to a new all-time high. This train doesn’t want to slow down.

There are several reasons for that. For starters, there is no sign of a recession on the horizon. Earnings so far this year have been good, interest rates are still historically low despite recent increases, global growth continues at a reasonable pace, inflation is contained, and consumer confidence is strong. None of the obvious triggers for an economic downturn are in evidence.

However, there is no question that U.S. stocks are overvalued by historic standards and the number of people expressing concern is growing. The Shiller p/e ratio for the S&P 500 is now at 31.15, higher than at any time since the 1880s except for just prior to the 2000 high-tech crash. It’s even higher than just before Black Tuesday in 1929! One unexpected event could trigger a flood of sell orders and plunge us into a new bear market.

What might that tipping point be?

Click through for a few possibilities.

Disappointing earnings. The third-quarter earnings season has just started and so far there is every indication that results will continue to be strong. That’s what this aging bull market needs to sustain itself for a little longer. But how long will that continue? According to the Open Market Committee of the Federal Reserve Board, the rate of GDP growth in the U.S. will slow from a projected 2.4 per cent this year to 2.1 per cent in 2018 and 2 per cent in 2019. A slowing economy may translate into decelerating corporate profits next year but that’s not an immediate concern for investors.

A major international debt default. We are warned repeatedly by every international economic agency that the world is awash in debt: personal, corporate, and sovereign. So far, the market has paid little attention to the growing debt bubble. But an unexpected default, especially at the national level, could change everything. That’s what happened in August 1998 when a cash-strapped Russian government devalued the ruble, defaulted on its domestic debt, and introduced a moratorium on payments to foreign creditors. Stocks plunged in response.

Collapse of a “too big to fail” company. Although the seeds of the subprime mortgage crisis were sewn years before, the trigger of the market crash of 2008 was the bankruptcy of Wall Street financial giant Lehman Brothers. Suddenly the rot that had permeated the system was revealed for all to see. Investors rushed for the exits, setting off the worst crash since the Great Depression. We’re still recovering today.

Protectionism. The Smoot-Hawley Act and other protectionist measures of the 1930s did not trigger the Great Depression but they certainly exacerbated it. We appear to be headed down the same road again under the direction of a U.S. administration that is more isolationist than any we have seen in over 80 years. We’ve already witnessed the death of the Trans-Pacific Partnership, at least as far as the U.S. is concerned. NAFTA may be next. Although that would be a blow to a range of businesses, from automobile manufacturers to agriculture, tearing up the deal probably would not send stocks tumbling. But if President Trump gets into a trade battle with China, as he repeatedly threatened during the campaign, watch out.

War. Wars don’t necessarily lead to a market crash. The markets digested the two Gulf wars and the invasion of Afghanistan without much distress. But a war with North Korea would be another matter entirely. It would likely involve nuclear weapons, the destruction of most or all of North Korea, the devastation of Seoul and the South Korean economy, and wreak human and economic havoc in northeast Asia. If China got involved, heaven knows where it would end. Of all the possible causes of a market collapse, this would be by far the worst.

Hopefully, none of these flashpoints will ignite in the next few months. But the possibility is always present. If you haven’t bullet proofed your portfolio recently, this is the time to start.

The extreme position is to get out of equities and put everything into cash and fixed income. But my policy has never been that black-and-white. This bull market could go on for quite a while and by cashing out now you could miss some great profits.

Rather, my view has always been to diversify your investments. You can control risk to a large extent through your asset mix – the higher the percentage of fixed income and cash, the lower your exposure to the impact of a market crash.

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.